A Discussion on Costs and Benefits

Economics revolves around the study of benefits and costs.  The goal of any economic action is to maximize net benefits (Total Benefits minus Total Costs).  That maximization occurs when marginal benefits (the incremental benefit achieved from one additional unit) is equal to the marginal cost (the incremental cost achieved from one additional unit).

Whenever there is discussion in the economic world on different policies (for example, minimum wage, government stimulus, or protectionist tariffs), we spend much time discussing the costs and the benefits.*  And, indeed, there are some studies that find that the estimated benefits for some government intervention will outweigh its estimated costs.

So, why then do I oppose these measures if the research may show a gain in benefits?  The reason why is simple: those who benefit are not necessarily those paying the cost (and, as is often the case, those for whom the benefit is intended don’t receive it).

Let’s take, for example, minimum wage.  As a casual search of this blog shows, I vehemently oppose minimum wage legislation in all its forms.  Minimum wage is designed to help the poorest workers earn a little more.  However, the beneficiaries of such legislation tends to be current minimum wage workers who are relatively better off and more secure in their skill set: they tend to be white, middle-class teenagers who work minimum wage to earn a few bucks.  Those who tend to pay the costs of minimum wage tends to be current minimum wage workers with fewer skills: they tend to be minorities, immigrants, or less-educated folks.  In the discussion of minimum wage, it fails its objective to adequately help the poorest workers.  Additionally, those who benefit are not the same as those who pay the costs.

Another example is protectionist tariffs.  The beneficiaries are clearly designated: the companies (and their stockholders, profit holders, and employees) protected.  The costs are harder to determine, but they are there: the purchasers who must now pay a higher price for the same goods.  Again, we see the costs and the benefits do not accrue to the same person.

This is where the discussion of costs and benefits in an aggregate sense runs into issues.  The discussion of costs and benefits, MC = MB and all that, that we economists discuss in our textbooks and undergraduate classrooms focuses on the costs and benefits accrued to the single economic actor (the individual, the firm, or the institution).  In which case, the economic actor pays both the cost and enjoys the benefit.  He/She/It can make a rational decision.**  However, when aggregating, the benefits do not necessarily accrue to the same actor as the costs and it can easily lead to poor decisions that make people worse off even if the benefits outweigh the costs!

The TL;DR version of this post is this: At an aggregate level, looking at the total benefits and total costs is meaningless.  One needs to look at who benefits and who pays.  By focusing only on the aggregate and not on the micro level, one may conceivably design a policy that increases total net benefits but those benefits accrue to someone for whom the policy wasn’t intended.

 

*I say “economic world” because in the political world, these items are often treated as costless.

**Rational does not mean perfect, by the way.  The fact that people may make bad decisions is not a case for government intervention or a breakdown in the market theory or its underlying assumptions.

11 thoughts on “A Discussion on Costs and Benefits

  1. The operative weasel word in these discussion is “society.” Whenever you see someone appeal to “society” for a decision, it should raise a red flag. “Society” (whatever that is) doesn’t make decisions, people do.

    Here’s a relevant quote from the progenitor of the sort of poor analysis you describe above:

    “It is not sufficient to contrast the imperfect adjustments of unfettered enterprise with the best adjustment that economists in their studies can imagine, for we cannot expect that any state authority will attain, or even wholeheartedly seek that ideal. Such authorities are liable alike to ignorance, to sectional pressure, and to personal corruption by private interests. A loud-voiced part of their constituents, if organized for votes, may easily outweigh the whole.”

    -A.C. Pigou

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  2. It seems that some of the same people who look at the cost/benefit “to society” of, say, minimum wage are often the same people who complain that the laws of supply and demand can’t be applied to labor, because that involves people, not some commodity.

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  3. I have said this before – I have approached the minimum wage debate with the preface of how is it economically feasible for us to have a national minimum wage? A business makes a profit based on turns and margins. Let’s say a business in NYC is able to turn 100 products in an hour for $10/each and makes 10% profit from the sale: $1,000 in Gross Revenue, $100 profit in 1 hour. Now, let’s look at a similar sale of the same product in a small town like Sierra Blanca, TX. The business is able to turn 5 products in an hour for $10/each and makes 10% profit from the sale: $50 in Gross Revenue, $10 profit in 1 hour. There is no way a small business in Sierra Blanca, TX could support an increase in minimum wage. The business would fail and the citizens of the community would be without those products. They would have to drive to Van Horn (30 miles away) or El Paso (80 miles away). It is best to allow the markets to determine of wage through negotiations between employee and employer.

    In a country as large and as diverse as ours, we should eliminate the national minimum wage. Those that support a national minimum wage have declared war on small-town America (as long as we are demonizing the opposition of an argument). Personally, I would not like any minimum wage legislation in any town or state, but we must chip away one link in the chain at a time.

    I also want to share Professor Don Boudreaux’s argument from his blog (Café Hayek) – Sorry I cannot find the link to it right now. I have been reading his work for several years and I remember this argument. We do not put cost controls (minimum pricing) on cars. What would happen if Congress passed a law saying the minimum price on a motorized vehicle will be $50,000? That would mean the Honda Fit or the Ford Focus would now cost $50,000. How many people would buy these vehicles? I, for one, would buy a much nicer car if I am being forced to spend $50,000 for a vehicle. I would imagine that any vehicle under $50K would go out of business. Now to put this into the labor price-fixing debate – The unskilled workers that cannot produce $15/hour worth of goods or services will become unemployable.

    I will post more on this later in my blog.

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  4. I asked a question on this topic over on EconLog and was somewhat disheartened to get no response. So I’ll try re-asking it here.

    There are lots of different challenges that different people make to the kind of classical or neoclassical economics that is often used to support free market solutions. One I’ve seen a lot recently is the one that goes like this: “Yes, supply and demand explains reality fairly accurately. But, absent empirical evidence, we have literally no idea whether any given supply or demand curve is likely to be elastic or inelastic, hence no way to tell whether a government mandated price floor or price ceiling would help or hurt the people it’s intended to help.”

    The minimum wage causes unemployment? Sure, but we have no way of even guessing how much. So absent empirical evidence, we don’t know whether it will cause a lot of unemployment, and be generally negative, or cause only a little, and be generally positive. Rent control causes housing shortages? Sure, but how much? Maybe the supply of housing is really inelastic. How can we possibly know? We need strong empirical evidence, else we are totally clueless.

    This is a direct challenge to the standard claims from free market supporters that, to the extent that simple economic models describe the world, a free market will produce the optimal outcome. It circumvents even the need to invent some weird argument, like monopsony or efficiency wages, for why the minimum wage doesn’t cause much unemployment. You don’t need to find a reason why the economic models aren’t right, because they are right: they’re right because they don’t say anything.

    I don’t know how seriously to take these arguments. It seems to me, as an observer of economics who has never actually studied it properly, that I must be missing something. Surely there wouldn’t have been such a strong consensus among economists, until around last year, that price ceilings and floors are a bad idea, if economic models don’t give any reason to expect these things to do more harm than good?

    Yes, yes, there are lots of other reasons to expect that governments will not implement these measures as they should, and special interest groups and public choice and all the rest of it. But… An argument that Law X is a good idea but governments aren’t competent to implement it properly is much weaker than an argument that Law X is a bad idea.

    So, what do you think is the reason that economists unanimously opposed these kinds of measures until a few months ago?

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      • (I’m the guy who made the post you’re replying to.)

        My question is on the extent to which you believe you can make predictions based on basic economics, supply and demand and so on, without gathering lots of evidence on the case in question. The extreme version of that, which seems obviously wrong, would be the claim that you can do economics a priori, entirely without empirical evidence. I think you and I and most reasonable people who have considered the question would agree that that’s nonsense – but that’s not what I’m talking about.

        What I do observe is that economists tend to assume that most supply and demand curves are fairly elastic unless evidence strongly suggests otherwise. The challenge to that view, made by ThomasH among others, is that this is an unreasonable assumption: that you cannot know whether the supply and demand curves for a particular case are likely to be elastic or inelastic, cannot even make a reasonable guess, without lots of empirical evidence on that specific product/industry/etc.

        So instead of the default assumption being that the market provides a roughly optimal outcome unless evidence suggests otherwise, the default assumption is that the market produces an outcome, which may be optimal or suboptimal, but we really have no idea. It means you can’t argue that if customers wanted X or if workers really disliked condition Y then the market would provide what they want, because how do you know? It all depends on the elasticities, and the elasticities are totally unknowable unless specifically investigated.

        Does that make any more sense? I’m not entirely convinced this argument is correct, but at first glance it seems quite strong, and I’m interested in what free market economists would say in response to it when it’s posed explicitly.

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        • Not really because we have lots and lots of evidence. With respect to Mr Hutchinson, he isn’t aware of the literature out there. We know the general elasticity of labor.

          But even then, to make a prediction, we don’t need to know elasticity. So long as the market isn’t perfectly inelastic, then the demand curve will slope downward.

          I don’t need to know the size of a drop of water or the size of a cup to know adding water to the cup will raise the water level.

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        • Anonymous

          You may be overthinking this. The basic laws of supply and demand, in this case demand, merely states that when the price of something rises, less of it will be demanded. (the demand curve slopes down) We can see that principle in action every day. When the price of hamburgers goes up, fewer will be sold. When the price of gas goes up we try to use less by driving less and planning our trips better. For some reason, this immutable law of human behavior is only challenged when the subject is labor.

          But like every other good and service, if the price of labor is raised artificially, as it is when the minimum wage is increased, less labor will be demanded by those who employ labor. It’s just that simple, but discussions often get confused because labor is supplied by people, and we tend to raise other considerations besides just the labor they provide.

          What we DO know is that when min wage is increased, some low skilled and inexperienced workers WLL lose their jobs. The moral question, then, is whether outside third parties have a right to cause those folks to be priced out of the market, even if some other workers do get raises and even if the overall effect was positive (it’s not). I think the answer is no.

          The best possible price for any individual’s labor is the one they and their employer agree on. No one else has better information with which to determine a price. Overall, then, the market will produce better outcomes than uninformed politicians and bureaucrats making arbitrary decisions for those directly affected.

          I doubt you will find many economists who have changed their thinking on this issue recently. You may find politicians who have become more vocal on the subject, but they aren’t to be trusted, as they all have very casual associations with the truth.

          Consider this: in the overall economy, if the price of low skilled labor is raised without an equal increase in productivity from those workers, the money for the higher wage must be taken from somewhere else. almost invariably it will come from other low skilled workers.

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  5. Anonymous

    … hence no way to tell whether a government mandated price floor or price ceiling would help or hurt the people it’s intended to help.

    Consider this: If a different price were better overall, it would already be the current price, and government mandating things wouldn’t be necessary. Why would it be necessary to force people to do something that’s better for them?

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